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Reasons for Small Business Failure

When businesses are on the brink of collapse, business owners need to act responsibly and swiftly to limit the damage. The first step is to recognise that insolvency is approaching. Failure to act may impact company directors personally. Most businesses that get into financial difficulty do so within the first year, when the business is trying to establish a market presence, reputation and customer base. On this page we explore why some small businesses fail so quickly and others thrive and survive?.....

What is Business Failure?

In the UK, there are two simple accounting based tests to determine whether or not a business is insolvent. The first is the 'Cash Flow Test'. This is the inability to repay business debt when the debt is due. For example, if a trade creditor can demonstrate to a UK court that they are owed more than £750 pounds, (and that the invoice has remained unpaid for 21 days), they have the legal right to petition the court for bankruptcy proceedings against the company. In this example, if the company could not afford to pay this relatively small invoice, they are approaching cash flow insolvency. Secondly, there is the 'Balance Sheet Test'. This is the point at which liabilities of the business are greater than the value of its assets. A successful and solvent business runs its balance sheet on a 'going concern' basis (in accordance with formal accounting procedures). However, the balance sheet of a business, (that is going through one of the various insolvency procedures), is prepared on a 'break-up' basis. In other words, the value of assets such as property, machinery and equipment is based on the value they would expect to achieve at an auction. This is likely to be at a massively reduced rate compared to market value.

If trade creditors are aware a business is going through some kind of formal insolvency procedure, it is highly probable they are unlikely to extend their credit facilities in the future, adding more cash flow worries and ultimately making business failure more probable. So with this mind, why do some small businesses fail so quickly and others thrive?...

Weak Competitive Differentiation

Many start-ups fail because the business owners have not properly thought through why their business is any different from their local competitors. They have either failed to carry out adequate market research to test their business proposition, or have failed to translate the results into a compelling and unique business proposition. They have failed to match their offering with the needs of their target market, while failing to differentiate their offering from established and trusted competitors. The job of the business owner is to understand the emotional needs of their prospective market, by obtaining evidence of buying criteria. By understanding what customers need and want, it is possible to match and develop products and services to meet those needs (more precisely than their competitors). So, understanding the motivations and reasoning's for a buying decision is absolutely essential in order to avoid business failure.

Lack of Management Skills and Experience

Most small business owners require the application of different business skills such as the selling, marketing, accounting, man management, organisation and planning and so on. Many fail because they are lack the skills and experience in a broad range of different disciplines, required to run a small business. Doing new things at the same time, and under pressure, is a sharp learning curve, particularly for people who have worked for large corporations for a long time. The culture shock can be startling. The freedom to control your own destiny can feel like a breath of fresh air, yet there are no support functions to phone up (as in large organisations).

When computers fail, tax forms need completing, invoices and the chasing and so on, the business owner must juggle precious time and effort. With the onset of recession and the increase in the number of redundancies, many competent and experienced managers of large organisations, believe that starting up their own small business is the best or only escape route. Yet most larger organisations divide their workforce by the skills of their employees. Rarely do managers get experience (or even see other parts) of the business such as the accounts department or credit control function. For self starting and ambitious individuals, skills can be learnt on the job and experience built up by learning from mistakes. For other the types of individuals that may prefer a more comfortable, structured, organised and controlled working environment, running a small business can be quite a culture shock.

Lack of Funding

Amazingly many small firms do not even produce a business plan outlining a profit and loss forecast, cashflow forecast, and detailed description of the business strategy of the new firm. Failure to produce such a plan before starting a business can mean a directionless entity, that has no quantifiable targets or goals upon which it can measure it is success or failure. Without the proper plan, firms commonly tend to realise that they need to raise business finance and overdraft facilities from their bank. These unplanned business debt repayments can become a major headache for owners and in some cases exceed the value of the assets of the business.

With banking lending criteria tightening up as a result of the credit crunch, fewer business bank loans are being provided and are becoming more expensive. Firms that have failed to budget for and raise capital at the beginning of the business inception are more likely to fail in the first three years. The credit crunch is also increasing the general cost of finance for small businesses with higher interest rate charges. Banks are shying away from risky business lending and are aiming to hoard cash (through enticing new savers instead), in an attempt to reduce potential bad debtors in the future.

Poor Management Accounting and Cost Control

All businesses must produce a profit and loss account, balance sheet and other statutory information. Yet, too many firms are failing to collate, analyse and make effective management decisions based on their own financial data. These are vital in order to understand and control escalating costs, track cash flow and understand profitability through ratio analysis such as gross margin, debtor days and sales growth. In particular, it is vital owners understand the break even point at which profit or loss occurs. This should include identification of fixed and variable costs, sales, expenses and gross profit. Confident projections of such break even analysis, (as part of a wider business plan), are an essential first step in raising capital from lenders. Owner managers tend to concentrate on customer relationships, marketing business ideas and tend to put aside financial accounting activities into the hands of their accountants. Accounting is often perceived as a bureaucratic and administrators nightmare, particularly where VAT is concerned. When starting up new businesses, a few business owners take the time and trouble to familiarise themselves with accounting principles, company requirements and procedures required to manage the financial aspects of a business.

Bad Debts and Late Debt Repayments

Managing cash flow is increasingly becoming the number one reason for business failure in the UK. Failure to monitor, track and understand the inflows and outflows of cash in the business can be devastating. Most new owners correctly concentrate on selling. They view administrative matters as a necessary evil and bureaucracy (particularly where statutory returns and accounts are concerned). Yet more and more small firms are suffering, due to an increase in bad debtors from their trade customers as well as larger organisations delaying payments to assist their own cash flow. Some businesses even fail to produce a cash flow forecast before they even begin and track actual results against forecast to understand what is going on. The unforeseen and unpredictable factors, (such as a tax bill that was not budgeted for or a bad debtor that could not have been predicted), all pile pressure on small businesses. Failure to make adequate contingency for unforeseen events is causing more and more firms to go into administration and receivership.

Breakdown of Relations Between Partners

Choosing your business partner is in some ways like choosing your spouse. You may spend your entire working day with them, making long-term and day-to-day tactical decisions that affect your livelihood and your family's income. Many businesses fail due to personality clashes that appear when a business is put under extreme pressure. Difficult decisions and compromises may have to be made to affect the survival of the company - if both partners cant not agree a way forward, separation is the likely outcome. For instance, if business partners cannot agree how costs should be cut or how new markets exploited, or fail to act through procrastination, then divisions and bad feeling naturally occurs. The basis of any type of partnership, whether it be a limited liability company, partnership, small business franchise or otherwise, revolves around trust and confidence between partners. The founding members of many firms fail to identify the appropriate skills of each of the partners, or fail to agree an growth and exit strategy.

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